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24 May 2016
Asset management
Air of mystery
Economist Insights
The Federal Reserve is not an advocate of mystery – quite
the opposite. Its default position is to reveal all to the
market, the only problem being that the market's faith in
the Fed's revelations is distinctly shaky. And when it comes
to monetary policy, one could go as far as to say, the logic
of the market is at odds with the logic of the Fed. Maybe
the Fed should reveal less and surprise more.
In courtship, it is often advisable to cultivate an air of mystery.
Reveal everything (figuratively) to a potential suitor, and you are
no longer in control of the conversation. The Federal Reserve
long ago abandoned their own air of mystery, and decided
to reveal everything to the market by publishing their rate
projections. But the only problem is that the market does not
believe the Fed's "dot plots". The Fed insist they are likely to
hike rates several times, but the market found that as believable
as a blind date claiming they are actually a secret agent.
In an effort to rekindle the romantic mystique, the Fed has
been trying to generate a bit more uncertainty. First the
minutes to the last meeting stressed that June was a 'live'
meeting. So, despite the market's scepticism, the Fed would
likely vote on whether to hike rates next month. Then Bill
Dudley, the influential President of the Federal Reserve Bank
of New York, commented that the market was now more
appropriately pricing in the probability of a June rate hike.
Before the minutes the market had only priced in a 4% chance
of a rate hike in June; that has jumped to almost 30% (Chart 1).
And the probability of two rate hikes this year doubled from
about 30% to 60%.
The pricing of rate hikes has been on a bit of a roller-coaster
ride. When fears for the US economy were at their peak back
in February, the market decided rates were on hold. Then right
before the March meeting the probabilities rose once more, only
to plummet again when Fed Chair Janet Yellen came across as
more dovish. Despite the improvement in the probability of a June
rate hike, the likelihood is still priced below where it was in March.
Joshua McCallum
Head of Fixed Income Economics
UBS Asset Management
[email protected]
Chart 1: Mystery re-unsolved
Market pricing of probability of rate hike by FOMC meeting date,
based on Fed Fund futures
100%
80%
60%
40%
20%
0%
Dec-15
Jan-16
One hike by June
Feb-16
Mar-16
Two hikes by year end
Apr-16
May-16
Source: Bloomberg LP, UBS Asset Management
And it is not just this year's rate hikes. The market has even
less faith in the Fed further out. The path of rates set out by
the fifth most dovish dot in the dot plots (which is probably
closest to Chair Yellen) still implies yield curves well above
the actual market yield curve. The disconnect can be divided
into beliefs about the speed of rate hikes, and also the
terminal rate at which yields peak (see Economist Insights,
On the Dot, for more details). This divergence widened
significantly compared to last year, despite the most recent
rise in bond yields (chart 2).
Chart 2: Mysterious disagreement
Difference between bond yields and rate implied by the FOMC fifth
dot rate path, basis points:
150
120
90
Chart 3: No mystery here
60
Difference between projected unemployment rate and long-term
unemployment rate, by year-end, % points
4
30
0
The Fed is kind enough to tell us what their estimate of the
neutral rate is, so we can get an idea of their forecast for the
unemployment gap. Every year the Fed has been forecasting
that the unemployment gap was gradually closing, and it is
one indicator where they have routinely been too pessimistic
rather than optimistic (chart 3). They forecast the gap to have
closed in 2015 and moved into being outright tight from 2016.
Jun Sep Dec Mar 16 23
May* May*
3y UST
Timing effect
Jun Sep Dec Mar 16 20
May* May*
10y UST
Long-run rate effect
Source: Bloomberg LP, UBS Asset Management. Note: May is current yields
compared to the March FOMC rate path.
Last year, the divergence between the Fed and the 3y US
Treasury (UST) was all about the timing of hikes. But this year
yields moved so low that the difference between the two is
increasingly driven by divergences in the long-run rate (the
rate at which interest rates get close to their natural rate). The
divergence in the 10y UST demonstrates that the market is as
doubtful as ever about the Fed's timing of rate hikes, but even
more doubtful about where rates will peak.
Trendy
The market is telling the Fed that growth is going to be lower
and that inflation is not going to warrant rate increases. Some
commentators argue that rates should stay low for longer
because trend growth is lower. Unfortunately, this does not make
any sense from the Fed's view of how monetary policy works
If you believe that trend growth is now lower, then economic
theory will tell you that you will need to hike sooner but the
rate hiking cycle will stop at a lower rate than in the past. This
is because a lower growth in trend, or potential, output means
that the gap with actual output is smaller. The smaller this output
gap is, the more likely that you will get inflation. But in any case
the Fed's objective is not actually high growth. The Fed's dual
mandate is maximum employment and stable price. So the
metric for the the Fed is how tight the labour market is. The logic
is similar to the output gap: what is the difference between the
current unemployment rate and the neutral rate.
Loose labour market
3
2
1
0
Tight labour market
-1
Mar-11
2011
2015
Mar-12
2012
2016
Mar-13
2013
2017
Mar-14
Mar-15
Mar-16
2014
2018
Source: Federal Reserve
When the unemployment gap closes, the Fed expects
wages to start rising and inflation pressures to rise.
Economic theory also tells us that when the gap is closed
interest rates should not be loose – they should be neutral.
The Fed's median estimate of the neutral rate is 3.25%.
The current rate is just 0.375%.
Not every Fed member would agree with this logic. Chair
Yellen herself has in the past talk about 'optimal control', the
idea that you might want to keep monetary policy looser than
you normally would but hike faster later on to compensate
(and possibly hike beyond neutral). But nonetheless the
Fed was rightly concerned that the market had completely
disregarded the possibility of rate hikes. If markets were not
even entertaining the possibility of hikes, there could be a lot
of disruption if the Fed surprises them.
Then again, if the Fed really wants to change market behaviour,
maybe they should have just surprised them. After all, an air
of mystery loses a lot of its impact if you go around telling
people that you have an air of mystery .
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